I hope that the New Year finds you happy and healthy! I'm pleased to report that the McCann Family is doing great and we successfully navigated another Family Holiday Travel Juggernaut (FHTJTM is a registered trademark of the McCann Family). This time we enjoyed the warm sun and sand of Islamadora, FL (the sport fishing capital of the world). We are rested, relaxed and ready to tackle 2013! I hope you are too.

Through the course of this year, I've had frequent conversations with clients and friends about our historically low interest rates and the affect on their financial plans. This leads me to my topic this quarter...

Fun with Mortgage Math

(Or: How to save $165,000 by spending $150 a month)

Given the historic low rates available for mortgages right now, refinancing your existing mortgage may make sense to your financial plan. Unfortunately, when many consumers look at the economics of re-financing, they are entirely too focused on the monthly payment. Your friendly banker or mortgage broker is probably not going provide much more analysis than the monthly payment because they are incented to sell you a loan. In reality, any re-financing decision should begin with a discussion of the total costs. For the purposes of our discussion today, I will be focusing on a (fictional) scenario for Sally and Sam Saver who are considering refinancing their existing loan. This data was drawn from average California mortgage rates according to Bankrate.com:

You'll notice a couple of interesting things. First is how much of the loan's interest (the green bar) is weighted to the beginning of the loan. The loan payment at the end of the first year is 77% interest. Although every loan will be different based on the rate and term, all fixed rate mortgages will have the same type of curve for interest vs. principle over time. As a result, for this particular loan, you pay 50% of the total interest of the loan after 11 years and 3 months. So you can see, Sally and Sam have already paid off a good deal of the interest due on their loan. They will now be paying off a greater and great percentage of their principle for the next 20 years. Here's a breakdown of the total cost of their loan:

30 yr fixed @5%

Monthly P&I

$ 2,684.11

Total Principal

$ 500,000.00

Total Interest

$ 466,278.92

Total Cost

$ 966,278.92

Here's a summary of where they stand after year 9 (beginning of year 10):

Paid up to year 10:

Interest up to year 10

$ 208,152.36

Principle Up to Year 10

$ 81,731.32

Total

$ 289,883.68

Paid after year 10:

Interest after year 10

$ 258,126.56

Principle after year 10

$ 418,268.68

Total Remaining Cost

$ 676,395.24

So now, let's check out their new loan. Assuming that they refinance only their remaining balance and don't add any additional costs to their loan, here are the numbers: 30 yr fixed @3.5%

Monthly P&I

$ 1,878.21

Total Principal

$ 418,268.68

Total Interest

$ 257,888.10

Total Cost

$ 676,156.78

Alrighty then, this is looking good! They have a $1,878 payment vs. $2,684. They're saving a cool $806 a month. In addition, since they're so smart, they've determined the total cost of the loan is almost exactly the same. Sign them up, right? Right?

Well, maybe. At this point Sally and Sam are much more informed than the average re-financer, but there is more to this. For example, Sally and Sam are 45. Their shiny new loan has a term of 30 years. That means they will pay off their loan when they are 75. What if their plan is to retire at 67? Will they want to carry a mortgage into the first 8 years of retirement? Also, what are they going to do with the extra money? If it goes to cash flow (i.e. they spend it) then their total costs are a wash. If they save it, or even a portion of it, they may create a much more solid plan and build greater wealth over time.

One thing that people often forget to explore - again because they are lured by the idea of a lower monthly payment - is to actually shorten the term of the loan. In this case, Sally and Sam could consider a 15 year loan. It has a double whammy benefit, because they shorten the term of the loan they pay less total interest PLUS it comes with a lower interest rate. Here are the numbers:

15 yr fixed @2.75%

Monthly P&I

$ 2,838.46

Total Principal

$ 418,268.68

Total Interest

$ 92,654.44

Total Cost

$ 510,923.12

In this case, Sally and Sam save over $165,000 in total cost by refinancing their loan and paying $150 more per month. Not a bad deal.

There is nothing particularly magic about this example. The results depend on the characteristics of the loans involved. So silly rules of thumb like, "You should re-finance if you can get 0.5% reduction in your loan rate" don't apply. You have to do the analysis on your own personal situation with the loans that are available to you. And you need to interpret the results based on your unique circumstances and life goals.

In Closing

The decision to re-finance your mortgage should involve much more than a simple determination of how much you can save each month. Your consideration should always include an analysis of total costs and review of your personal financial situation. If you have any questions on making a re-finance decision, or any other financial matter, don't hesitate to contact me. Also, if your friends or family have questions about any financial issue, please feel free to make an introduction or forward this letter. We provide Financial Planning and Investment Management services and would be happy to talk with your acquaintances. We will treat your friends and family with the same care and diligence that we treat you.

Thanks, Brian McCann, CFP®

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Disclaimer

Note: The contents of this site are general in nature and not intended as specific investment advice. All investments are subject to risk; including loss of investment value. If you have any question regarding investments or concepts in these pages, please consult with an investment professional.